One of the advantages of an LLC’s default tax structure is that, unlike a corporation, it is not liable to double taxation. Instead, all gains and losses will be distributed to the members. In this essay, we’ll go over how pass-through taxes works, its benefits and drawbacks, and other solutions.
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What exactly is pass-through taxation?
Pass-through taxes applies to sole proprietorships, partnerships, S companies, and LLCs. Single-member LLCs are treated as “disregarded entities” by the IRS, whereas multi-member LLCs are treated as general partnerships.
Entities that pass through
Flow-through taxation applies to both default tax structures (disregarded entity and partnership), which means that rather than paying corporate taxes, an LLC’s revenues pass through to its members and are recorded on their personal tax returns. Profits are only taxed once, at the individual income tax rate of each member.
Pass-through firms must additionally pay 15.3% of their earnings in employment tax. Consider learning more about S corp status if you want to save money on employment taxes.
Do I Have to Pay Taxes on My Retained Earnings?
The IRS will not distinguish between dispersed profits and retained earnings if your LLC elects to be taxed as a disregarded company or a partnership. This is due to the IRS’s view that these enterprises are not independent entities from their owners. Any revenues generated by the firm are immediately deemed personal profits of the LLC’s members. As a result, an LLC taxed in this manner cannot reduce its tax burden by reinvesting earnings in the firm.
If an LLC wants to benefit from retained profits while still enjoying pass-through taxes, S corp status may be advantageous. Owners of S corporations who labor for the company have their earnings allocated as salaries rather than dividends. The remaining earnings might be reinvested in the company or distributed to shareholders as non-dividend payments.
On their regular earnings, owners must pay both personal income tax and self-employment tax. Retained earnings, on the other hand, are never liable to self-employment tax, even when given to owners. To avoid raising red flags with the IRS, S corp owners must restrict the amount of earnings retained in the firm and ensure that owners are paid a “reasonable compensation” depending on their position and industry.
How Do Losses Affect Pass-Through Taxation?
Losses are reported on personal tax returns by LLCs taxed as pass-through businesses in the same way that profits are. While the details may vary based on your firm, your reported losses will normally decrease your total tax burden.
The Benefits and Drawbacks of Pass-Through Taxation
Pass-through businesses provide their owners with two major advantages:
The structure is straightforward, and it enables owners to blend personal and corporate income for tax reasons. This is especially beneficial for small firms wanting to simplify their processes.
All firm gains are taxed just once, at the owners’ individual tax rate. This is in contrast to corporate earnings, which are taxed at the corporate rate first and then at the shareholders’ personal rate when given as dividends.
These benefits might make pass-through taxes an appealing alternative, but it does have certain drawbacks. One significant disadvantage of pass-through corporations is that they must pay employment tax on all earnings. This 15.3% tax includes both the employee and employer responsibilities for Social Security and Medicare. While S corporations may lower their employment tax burden by keeping a part of their profits, all wage earnings are liable to both income tax and employment tax.
The New Pass-Through Tax Deduction of 20%
The Tax Cuts and Jobs Act of 2017 added another benefit to pass-through businesses by offering a 20% tax deduction for owners of pass-through entities. This implies that owners may deduct up to 20% of the company’s QBI on their personal tax return. While many company owners would profit from this deduction, there are a few factors to consider.
Single taxpayers earning less than $160,700 and joint filers earning less than $321,400 are entitled for the maximum 20% deduction on pass-through income in 2019, regardless of the sort of company they operate.
Some restrictions apply to single taxpayers earning more than $207,500 and joint filers earning more than $415,000. Personal service company owners who exceed these criteria are not entitled for any deduction. Individuals in certain company categories may still be eligible for a limited deduction depending on the amount of wages paid and the kind of property owned.
Those with incomes within the aforementioned criteria are entitled for a limited deduction regardless of the sort of pass-through company they operate.
Is it necessary for me to choose pass-through taxation?
While a single-member LLC and multi-member LLC are treated as pass-through entities by default, owners may opt to be taxed as C corporations. If an LLC elects to be taxed in this manner, its company earnings will be taxed at the current 21% corporation tax rate. All gains delivered to owners as dividends are subsequently taxed at the individual income tax rate of each member. This situation is known as double taxation.
Retained profits of C corporations are not liable to income tax if they are reinvested in the firm rather than given to shareholders.
The IRS has set a $250,000 cap on business retained profits. A corporation that collects more than this amount with no apparent purpose for it inside the firm may face a 20% accumulated profits tax on any retained cash in excess of the threshold.
When Is It Beneficial to Be Taxed as a C-Corporation?
While pass-through organizations are highly appealing business choices, deciding to be taxed as a C corporation may provide an LLC with a number of advantages:
There is no self-employment tax.
Formal investors often prefer to cooperate with C corporations.
More potential costs write-offs:
Premiums for health insurance
Insurance for life
Health-savings accounts
Plans for retirement
Memberships to gyms
Company automobiles
Housing assistance
Potential state tax deductions
C corporations may deduct their federal tax payments in several states that have their own corporate income tax. This may or may not be an advantage based on your state’s corporation vs. pass-through tax obligation.
Potentially lower total tax burden.
Since the Tax Cuts and Jobs Act decreased the highest corporation tax rate from 35% to a flat rate of 21%, some company owners in higher personal tax brackets may prefer corporate taxes over pass-through taxation.